Understand Initial Coin Offerings (ICO)

Initial Coin Offerings (ICO)

An Initial Coin Offering, or ICO (Initial Coin Offering), is a financing mechanism for a project or company made over the Internet through the massive sale of a cryptoactive. It is a case of crowdfunding, which is a method of financing a project or company by collecting many small amounts of money from a large number of people, typically over the Internet. The term can be analogous with “mass sale” or crowdsale.

Operation of an ICO

In an ICO, the project in search of money issues a certain amount of cryptoactives or tokens on top of a previously existing Blockchain platform, such as Bitcoin, Ethereum or Waves, and delivers them to investors in exchange for cryptocurrencies or, in a few cases, fiduciary money like the dollar or the euro. The entire operation is carried out using intelligent contracts that are responsible for automating the process of distributing tokens according to the requirements established by the owner of the ICO. Thus, when the payment condition is met, the contract assigns and sends to the investor’s portfolio the corresponding amount of tokens automatically.

These contracts are audited, or developed, by specialized companies (Zepellin Solutions for example), using industrial-level security standards and best practices, in order to ensure that the code works as expected, eliminating errors and enhancing security.

The participation procedure in an ICO can vary from including the previous registration of the participant and an estimate of its investment or simply taking it to the website to make the purchase of the cryptoactive.

The first ICOs, such as Mastercoin or Ethereum, consisted of a single phase or execution period and offered a bonus to investors for their early participation, which was accessible to anyone. The most recent ICOs are usually executed in two phases, a first called pre-ICO, pre-sale or private placement, which aims to raise as much money as possible from private investors during this non-public period, offering them a discount or bonus. greater than those who participate in the second phase or ICO, for being willing to take the risk of giving a large amount of money to an immature project.

The most used platform to realize ICOs is the blockchain of Ethereum, for two basic reasons: the ease of creation of compatible ERC20 tokens and automation of the process of distributing the tokens through intelligent contracts supported by this blockchain. Another very used platform designed especially for the creation of tokens is the blockchain Waves.

The ERC20 protocol is a standard method that guarantees interoperability between tokens. If all the tokens created in the Ethereum network use the same standard, those cryptoactives will be easily interchangeable and will be able to work immediately with decentralized applications (dApps) that use the ERC20 standard. What makes a “standardized” token is that it uses a certain set of functions, which facilitate its integration into projects with less fear of errors. If several tokens behave in a similar way, calling the same functions in the same way, then a dApp can interact more easily with different sub-currencies.

Differences between IPO and ICO

An Initial Public Offering or IPO (Initial Public Offering) is the process of selling for the first time a portion of the shares of a company to the public in the capital market, its buyers becoming shareholders of the company. On the contrary, the ICO sells a cryptoactive or utilitarian token that does not represent equity capital in the company or project, but allows its holder to interact on the platform to be launched in the way that the creators have it (for example, by activating a instruction or generating a digital asset in a game) and exchange it in the market for other cryptoactive or fiat money. In addition, the token may represent a property or royalty right over the benefits of a project or company, as agreed by the issuer.

Characteristics

The main characteristics of the ICO as a source of financing for projects and startups are, among others:

Globality: by using the Internet as a means of access to mass selling, anyone in any part of the world can invest without limitations other than those established in the ICO.

Ease: investors can agree directly on the platform without the need of brokers or brokers as intermediaries, at any time during the ICO.

Unlimited investment: investors can make large or small purchases of the offered tokens, limited only by the conditions that the owners of the ICO impose. Large investors can even buy in the pre-ICO, thus ensuring better discounts or promotions.

Little regulation: Another big difference of the ICO with the IPO is that there is little regulation of these in the world, so the protection of the investing public is minimal or nonexistent. The IPO regulation obliges the promoters of the IPO to disclose, initially and periodically, a set of relevant business information about their business operations, financial situation, operating results, risk factors and management. Until now, ICOs are banned in China and South Korea and regulated in the United States as securities.

Models of Sale of Tokens or ICO

From the ICO of MasterCoin (now Omni Layer) in 2013, the first ICO in history, which raised 500 thousand dollars in BTC at that time, other mechanisms have emerged to sell different tokens that aim to correct the deficiencies of the first models. These mechanisms include limited sale, unlimited sale, hybrid limited sale, reverse Dutch auction, Vickrey auction, proportional reimbursement and many other mechanisms. Some of these mechanisms are described below, according to analysis by Vitalik Buterin, creator of Ethereum.

ICO of limited sale (capped sales): in which a fixed number of tokens are sold at a fixed price and, therefore, at a fixed valuation. This scheme was used in the massive sales of MasterCoin, MaidSafe, WeTrust and other cryptoactive products, with different levels of success, due to the use of one or more cryptocurrencies as a payment method, as this generated economic losses for some of the investors to the exchange fluctuations between the payment currencies.

During 2016 and early 2017, the limited sale design was the most popular. Limited sales have the propensity to be over-subscribed by those interested, so there is a great incentive to enter first, which leads them to pay high transaction fees to buy first, bringing as a consequence high concentration of tokens in a few hands , many frustrated stakeholders and euphoric miners. Examples of this ICO model were First Blood, which raised 5.5 million dollars in 2 minutes, and BAT (Basic Attention Token), 35 million dollars in 30 seconds.

ICO of unlimited sale (uncapped sales): in which as many tokens are sold as investors want to buy. Having no limit on the issuance of coins gives participants a great uncertainty about the valuation they are buying, in addition to presenting the issuers as greedy. It is likely that many people want to pay $ 10,000 for a certain number of tokens of an ICO, if they knew for sure that this amount represents 1% of all existing cards. But many of them would be leery if they bought an amount of, say, 5,000 tokens from the ICO, with no idea whether the total supply would be 50,000, 500,000 or 500 million.

Reverse Dutch auction: it is a limited sale, with a limit of X million dollars. However, the portion of tokens that would actually be given to buyers depends on how long it takes for the sale to finish, that is, as soon as the limit is reached. For example, if the first day ends, only 5% of the tokens will be distributed among the buyers and the rest will be retained by the ICO team; if it ends on the second day, it would be 10%, and so on.

The objective of this is to create a scheme in which, if you buy at time T, you are guaranteed to buy in a valuation that is at most 1 / T. The objective is to create a mechanism where the optimal strategy is simple. First, you personally decide which is the highest valuation you would be willing to buy (call it V). Then, when the sale begins, do not buy immediately; rather, wait until the valuation falls below that level, and then send your transaction.

There are two possible outcomes:

The sale closes before the valuation falls below V. So, you are happy because you were left out of what you thought was bad business.

The sale closes after the valuation falls below V. Then, you sent your transaction, and you are happy because you entered what you thought was a good business.

However, many people predict that due to the “fear of missing it,” many people would simply buy “irrationally” the first day, without even looking at the valuation. And this is exactly what happens: the sale ends in a few hours, with the result that the limit of X million dollars is reached and only a small percentage of the tokens (~ 5%) is distributed among the buyers, leaving the majority held by the ICO Team. This leads to the risk that they could act as a central bank with the ability to manipulate cryptocurrency prices to a large extent.

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